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The only thing worse that having to pay expenses each month is not knowing how much you are going to have to write the check for. Being able to estimate business costs accurately can help you plan for the future and see trouble on the horizon. There are many ways to estimate costs, and each one is a different blend of difficulty and accuracy. Knowing some of these basic methods may help you choose the right one for your firm.

Least Squares Regression

For many business owners, least squares regression is a perfect blend of accuracy and ease of use. By analyzing past data, this technique uses mathematical estimation to determine the variable and fixed components of a cost, and provides an equation that can be used to predict future expenses. While this sounds complicated, the mathematics are built into most commercial spreadsheet programs, so adoption is as simple as entering your bill history and clicking a few buttons.

High-Low Method

If you are interested in a quick and easy way to estimate costs that still has some accuracy, the high-low method may be right for you. The method uses the highest and lowest levels of activity to calculate the fixed and variable components of the cost, but it ignores all of the data that isn't on the extremes. If the highest and lowest levels of expense are representative of the costs you are estimating, then you're in good shape. If not, this method can overestimate or underestimate costs.

Scattergraph

The scattergraph method is the quickest and easiest method to estimate costs, but it has some serious accuracy concerns. To use the scattergraph method, you simply plot the cost vs. the level of activity on a graph, and draw what you think is the best-fit line through the points. Once you've determined the best-fit line, the slope of the line is the variable cost per unit, and the fixed cost is the point where the line crosses the y-axis. The problem with the scattergraph method is that each person has a different idea of how to draw the best-fit line, giving each person a somewhat different estimate of the cost.

Statistical Modeling

For the largest of small businesses, statistical modeling can be a very accurate method of cost estimation. Industry-specific models are able to predict such complex variables in cost computations as hotel vacancy, food costs, and stock-based compensation expense. While these methods can be very accurate, the cost of implementation can be high, which puts them out of reach for many small firms.

References (1)

Managerial Accounting; Ray Garrison, et al.

About the Author

John Freedman's articles specialize in management and financial responsibility. He is a certified public accountant, graduated summa cum laude with a Bachelor of Arts in business administration and has been writing since 1998. His career includes public company auditing and work with the campus recruiting team for his alma mater.